Why The Government Taxes Corporations

By Revanza Almaas, a Directorate General of Taxes officer

Economists are largely critical of corporate taxes, arguing that they stifle economic growth by discouraging investment and distorting markets. They further emphasize the difficulty of determining who ultimately shoulders the burden of these taxes, as corporations have the ability to pass them on to consumers or shareholders.

In contrast, the general public expresses strong support for corporate taxes. Corporations are perceived as wealthy entities that can afford to contribute more, and corporate taxes are seen as a tool to achieve tax fairness (progressive taxation).

I think neither side holds the entirely correct view. While economists may be right about the negative economic consequences, there can still be compelling reasons to tax corporations. These reasons might encompass social objectives like reducing inequality, or simply the practicality of corporate taxation as a reliable revenue source.

The most effective approach might be to find a middle ground that balances economic efficiency with other societal goals. This could involve reforming corporate tax structures to minimize the negative economic effects while still raising revenue. While there may not be a single, perfect argument for taxing corporations, there are numerous reasons supporting some form of corporate taxation under specific circumstances. When these reasons are considered within the context of a particular country, it often becomes clear that some form of corporate taxation is not only desirable but may already be close to the optimal solution, given the practical limitations. I believe many countries, including Indonesia, could benefit from significant reforms to our corporate tax policies.

Although corporate taxes can stifle economic growth, there are three specific scenarios where corporate taxes can be beneficial, thus makes itself desirable.

1. Addressing Negative Externalities: Businesses can sometimes create unintended negative consequences, like pollution. A tax on pollution (like Pigovian tax) would incentivize companies to reduce it, bringing their operations closer to being socially optimal. This kind of corrective tax directly improves social well-being by tackling these external costs.
2. Capturing Economic Rents: When corporations earn excess profits that aren't a result of efficient resource allocation, these are considered economic rents. A tax on such rents wouldn't distort economic decisions because these profits are above what's necessary for efficient production. This approach could be particularly relevant for industries like natural resources or those with monopolies, where rents are more likely to arise.
3. Taxing Foreign Corporations: Foreign firms may have inherent advantages, and taxing their profits could be a way for the host country to claim a piece of that benefit. However, the argument is weakened by the difficulty of determining who truly bears the burden of such taxes. These costs might be passed on to foreign consumers through higher prices or to foreign investors through lower returns. Additionally, designing these taxes effectively can be complex. While taxing foreigners might be appealing from a purely nationalistic perspective, the economic benefits are unclear.

Apart from its desirabilities, corporate taxes, despite potential drawbacks, are likely to remain a fixture in most tax systems because of these reasons that may prove that they are necessary.

1. International Pressures for Corporate Tax Conformity: The global prevalence of corporate income taxes creates a situation where deviating significantly can be disadvantageous. Countries are pressured to maintain some form of corporate tax, at least resembling the standard model, to avoid hindering cross-border investment and tax revenue collection. The dominance of some countries like United States in international investment further strengthens this pressure. American corporate tax policies can limit the options of other countries, as significantly different Indonesian tax structures might be deemed incompatible and discourage foreign investment.
2. Corporate Taxes Patch the Holes in Personal Income Taxes: Beyond international considerations, corporate taxes play a crucial role in plugging loopholes and inefficiencies within personal income tax systems. For instance, they capture capital gains accrued within corporations that individuals might otherwise avoid by retaining profits instead of distributing them as dividends (taxable income for individuals). Additionally, corporate taxes can be used to withhold taxes on dividends paid to individuals, aiding enforcement of the personal income tax. This complementary function becomes even more important when considering the limitations of personal income taxes. The complexity of taxing individuals who receive income from various sources, like capital gains or foreign sources, makes corporate taxation a vital tool for ensuring a more comprehensive tax system.

We have discussed why coporations might be desirable or necessary for certain reasons. We will discuss how corporate taxes may be convenient to apply due to their ease of administration and enforcement, thus a system without it just seems virtually inconceivable.

1. Corporations as Conduits for Tax Collection: The large volume of financial activity that flows through corporations makes them ideal targets for tax collection. They maintain detailed records and are easier to track than individual taxpayers. This eases the administrative burden for tax authorities who can gather information and enforce tax collection more effectively. In this sense, corporations act like a modern-day tollbooth where the government can efficiently collect taxes.
2. Corporations as a Source of Tax Information: Businesses hold a vast amount of data on financial transactions, making them a goldmine for tax authorities. Just like customs agents historically monitored imports and exports, governments rely on corporations to provide information on income, sales, and other transactions that can be taxed.
3. The Political Landscape of Taxation: Public perception plays a significant role in tax policy. People generally expect large corporations to contribute their share through taxes. This political pressure can compel governments to levy corporate taxes, even if the economic benefits are debatable. Politicians who ignore this public sentiment risk losing favor with voters.
4. Corporate Taxes as Policy Tools: Governments can use corporate taxes to influence corporate behavior and achieve economic or social goals. These goals might include encouraging investment in specific sectors, promoting exports, or stimulating small businesses. By offering tax breaks or imposing penalties, corporate tax policy can become a tool for shaping economic activity.

In conclusion, corporate taxation, while subject to economic critiques, presents a compelling case for its continued presence within most tax systems. This durability stems from a confluence of factors. From a policy perspective, corporate taxes offer desirable features such as mitigating negative externalities, capturing economic rents, and potentially generating revenue from foreign corporations. Additionally, they serve a necessary function by conforming to international tax norms and complementing personal income taxes. Beyond these policy considerations, corporate structures offer practical advantages for tax administration and enforcement due to the ease of information collection and public support for such levies. Corporate taxes' role in generating revenue and achieving social objectives suggests they will remain seated in fiscal policy.

*) This article is the author's personal opinion and does not reflect the attitude of the agency where the author works.

The content on this page may be copied and reused for non-commercial purposes. However, we kindly request users to give credit to the source by providing a link back to the original page. Thank you for your cooperation.